ABSTRACT
In this chapter and the next we consider the proposition of purchasing power parity (PPP). This concept has been widely used to measure the equilibrium values of currencies and is often the one an economist will first turn to when asked if a currency is over- or undervalued or not. PPP is also a relationship which underpins other exchange rate models, such as the monetary model considered in Chapters 4–6. In his comprehensive 1982 survey of the PPP literature, Jacob Frenkel referred to the ‘collapse’ of the PPP hypothesis. It is therefore perhaps surprising that since Frenkel’s survey there has been a huge resurgence of interest in the PPP hypothesis. Much of this interest has arisen because of the development of new econometric methods, such as cointegration and non-stationary panel methods, and the application of these methods to testing PPP. The recent PPP literature has produced the so-called PPP puzzle (Rogoff 1996), which concerns the reconciliation of the high short-term volatility of the real exchange rate with the slow mean reversion speed of the real exchange rate. As we shall see in succeeding chapters, the volatility of the real exchange rate can be explained by, inter alia, speculative bubbles, port-folio effects and liquidity effects. The PPP puzzle arises because if it is indeed, say, liquidity effects which drive real exchange rate volatility then the mean reversion speed of the real exchange rate would be expected to be relatively rapid (standard macro-theory suggests that in the presence of sticky prices, the real effects of liquidity shocks on real magnitudes should be dissipated after around 2 years), but in practice mean reversion speeds are painfully slow. 2
